The market for micro-finance is booming and cross-border funding for micro-finance institutions (MFIs) is increasing. It is important for microfinance institutions to show their effect in reducing poverty to maintain long-term interest of investors.

In our recent research, we investigated the relationship between social capital formation and the performance of MFIs across 100 countries. The focus on social capital is important because MFIs use group loans with joint liability.

Previous research has focused on the institutional and macroeconomic factors as drivers of MFI performance. We added to this strand of research by focusing on three types of social dimensions - fractionalisation (the chance that two random individuals from the same country are not from the same religious, ethnic, or linguistic group), generalised trust (how fast individuals can build respect, acceptance, friendship, sociability through social interaction) and individualism (individuals develop their social networks according to their own interest, i.e., they are not bound by social norms to restrict their social interactions within their kin) as proxies for the extent to which social capital formation is facilitated.

Overall, our results indicated that MFIs do well, in terms of both financial and social objectives, in societies where social capital can be developed more easily. We also found that in societies characterized by higher (linguistic, ethnic, and religious) fractionalisation and high-trust societies, MFIs have lower financial and social performance. These results are important insofar as they shed light on the social contexts within which microfinance can be successful. This has significant policy implications.

An important implication of our results is that microfinance may not be the best solution to address poverty in all parts of the world. The success of microfinance models depends on the extent to which the society is conducive to social capital development. The success of the Grameen Bank in Bangladesh led to setting up similar microfinance initiatives around the world. Yet, the mechanism of the Grameen Bank model is rather specific, and replication of this model with scant regard for societal factors may lead to failure.

The paper can be downloaded here.